Stock and Bond Market Update (10/19-10/23)

Stock Market Analysis

While stocks rose last week, bond prices did not. Treasury yields rose between 3 and 7 basis points across the yield curve. After the week’s moves, we find year-to-date gains of only 0.2% in long term Treasuries. Intermediate term treasuries have the best returns, but they are only up 2% so far this year.

The dollar remained strong with the DX dollar index rising about 2.7%. It is now ahead about 13% in the past year. Such strength is bullish for bonds. According to many observers: Higher prices will lead to lower sales for large US firms who market abroad. A decline in sales will slow the need for borrowing. Fewer bonds will need be marketed so existing bond holders will enjoy rising prices.

China just cut interest rates for the sixth time since November. Our Fed meets this week, but it won’t likely do anything. We have a debt ceiling showdown going on in Washington, but it will be raised and it will only have a temporary impact on bond prices. Inflation remains stable and weak economic news should continue to benefit bond investors.

Our intermediate term bond indicators confirm a neutral outlook toward bonds is appropriate here. However, our longer term indicators are more positive, suggesting a rising level of economic distress. From regional Fed reports to Industrial Production, we have seen certain sectors of the economy slowing. This will likely play out in stock and bond markets, with opposite results. Extended valuations, a slowing economy, too strong a dollar, and too many bulls could create problems for equity investors but opportunities for bond investors. We continue to favor moderate durations and high quality bonds.

F James, Ph.D.

Bond Market Analysis

For the fourth week in a row, the S&P 500 advanced. This week it gained 2.1% while smaller issues such as those in the Russell 2000 advanced 0.3%. Advancing issues outpaced decliners by a moderate amount. Sectors with the best performance include Technology and Industrial, which both gained nearly 4%. Meanwhile, the Healthcare, Utility and Energy sectors fell.

The market advance seems to be in direct contrast to earnings data. So far this earning season, we’ve seen roughly 34% of the companies report. Overall, the results have been poor. According to Bloomberg, among S&P 500 stocks, earnings and sales are both down over 3%.

Why the earnings downturn? A number of companies are understandably blaming the stronger dollar. Often a stronger dollar makes our exports more expensive for our international partners and they buy fewer of our products. Unfortunately, we are seeing little relief on this front. In the last week and a half, the US Dollar Index is up over 3%, putting more pressure on large export firms.

Unfortunately, the domestic arena is not looking much better. The Conference Board’s Leading Economic Index declined. Further, their Coincident-to-Lagging Index reached its lowest level of the year. Fed reports out of Kansas City and Chicago are also negative.

Still there are pockets of economic opportunity. Housing traffic, which indexes the number of prospective home buyers, remains at healthy levels. Additionally, housing starts grew at an impressive 6.5%.

Further opportunities may be forming in value stocks. Growth issues, those with above average earnings expectations, are often viewed as a high reward/high risk proposition. They have been in vogue over the last 10 years. In fact, the Russell 3000 Growth Index has outpaced the Russell 3000 Value Index by about 2.3% annualized over this period. Historically, this has been an uncommon event. So far in October, we have begun to see a return towards value stocks.

Examining our most accurate indicators on a weighted-basis, we continue to find an improving picture for the intermediate term. This also coincides with certain seasonal affects, which favor the end of the year. The recent rally we have seen can continue for a time. However, there are longer term risks. Valuation levels, including CAPE (Cyclically Adjusted Price-to-Earnings) and Stock Market Value / GDP, are elevated. Longer term caution will likely be needed, but for now investors should continue to enjoy the stock rally.

David W. James, CFA